| |
Stocks of a particular style generally share long-term risk, return, and
correlation characteristics. This helps investors and financial planners
decide how to allocate their assets. An equity fund's style refers to
the types of stocks the fund holds.
Active mutual fund managers define their own investment style, which guides
them in picking individual stocks. For example, a fund manager may manage
a growth fund that reflects a style preference of growth stocks.
The problem with investment style is that it is not consistently defined
within the industry. Terms such as large, small, value, and growth have
a wide range of definitions. This lack of specificity makes it difficult
for investors to measure their risks and rewards, and easier for active
managers to claim market beating returns over a nebulous benchmark.
A growth style includes stocks that are experiencing rapid growth in earnings,
sales, or return on equity. Growth stocks tend to carry low book-to-market
ratios, high price earnings ratios, and usually offer no dividend yields.
Growth stocks are priced much higher than their book values, indicating
a large portion of the purchase price goes to goodwill. Goodwill is basically
the difference between the price and the book value. Growth is somewhat
of a misnomer. The price paid for goodwill is often deflated by news of
lower than expected earnings growth of these companies. Growth stocks
are expected to underperform value stocks and the total market.
A value style includes stocks that tend to carry high book-to-market ratios,
low price earnings ratios, high dividend yields, and are often described
as being in distress. They are thus perceived by investors to be of higher
risk, but investors need to remember that higher risk equates to higher
expected return. The shareholders of value stocks have a high cost of
capital, which equates to a higher expected return for the capital provider.
The capital provider is the investor, or the capitalist. Value stocks
may receive a lot of negative publicity and experience a downturn in their
business.
The styles of large, small, and micro are based on a company's share price
multiplied by the total number of shares. Companies are ranked and grouped
into categories that vary substantially within the investment industry.
For example, as of September 2001, the Russell 2000 index of small cap
stocks had a weighted average market cap of $800 million, while the DFA
small cap index had $600 million, and the DFA Micro cap index had $250
million. Morningstar, Russell, Lippers, Barra, Wilshire Associates, DFA,
Morgan Stanley Capital Indexes, and Standard and Poor's are all considered
reliable sources of style criteria. Each has its own set of rules for
measuring value, growth, large, small, international, or emerging markets.
It is no surprise that the active investor is dazed and confused.
6.2.2
Style Drift
Style drift refers to the tendency
of active managers and actively managed mutual funds to deviate from their
stated or expected investment style. This drift can occur gradually over
time, as in the case of a "small-cap" manager buying larger
and larger companies as their fund asset base grows. Style drift can also
occur abruptly if an active manager perceives opportunities for higher
returns from a different style. For example, a U.S. large company fund
may purchase a high percentage of Mexican stocks, changing the fund’s
style.
6.3.1 Style
Drift Alters Risk Exposure
Style drift creates numerous problems
for active investors. It keeps them from maintaining reliable asset class
allocations for their portfolios. This results in inconsistent exposure
to risk and the resulting variations in expected average returns.
Experts widely agree that over time, asset class allocation is on average
the single most important determinant of variance in investment performance.
The best way to design a portfolio's asset class allocation is to use
historical asset class data.
Active investors cannot use historical asset class data to design asset
class allocations for their portfolios. Many design them by relying on
style labels such as "value," "growth," "large"
or "small" that are carried by active mutual funds. They may
even neglect to design them at all. An active fund usually does not relate
to the risk and return potential of any single asset class. It is unclear
how the reliance on labels that supposedly identify these asset classes
can help active investors design asset class allocations for their portfolios.
This task can prove even more difficult for an active investor who invests
in a separate portfolio of individual stocks and bonds. It is essentially
impossible to rationally design a portfolio's asset class allocation when
the building blocks of the invest |
